Interest Rate versus Annual Percentage Rate (APR ): What is a true measure of the “cost” of borrowing to the consumer?

 I have a particular industry issue that has perplexed me for some time, and this is to do with interest charged in the Card Payments Industry. Allow me to explain.

Interest rates and annual percentage rates (APRs) are two frequently conflated terms that refer to similar concepts as regards the cost of borrowing, but have subtle differences when it comes to calculation. When evaluating the cost of a loan or line of credit, it is important to understand the difference between the advertised interest rate and the APR. The latter includes certain additional costs or fees.

The following is a list of common fees that are normally packaged into a mortgage’s APR, as an illustrative example. Of course, every lender is different, and these are just rough generalisations. It is always best to ask lenders to list all fees “packaged” into individual APRs to be entirely sure. Nevertheless, here are some “additional fees” included in an APR arrangement:

  • Administration fee
  • Application fee
  • Mortgage insurance
  • Mortgage broker fee
  • Audit Fee
  • Closing fee
  • Processing fee
  • Refinance fee
  • Underwriting fee

An interest rate on the other hand is different in that it is simply a percentage charged on the total amount you borrow, or save. It is purely a number that represents the cost of borrowing on the principal amount. There are no hidden charges as such, apart from the “margin” over the benchmark rate itself, which is always clear to the customer in the example of a mortgage. There may be other facility fees and/or early redemption fees; but again, all these are covered in the final offer document to the borrower.

Therefore, given this difference, it is important to understand and be aware that interest rates do not offer the absolute accuracy a borrower requires as regards identifying the exact “cost” of the facility, when determining which rate from which lender is the best deal; however, an APR does. It does this by factoring into the interest rate other additional costs associated with the loan. For most loans, lenders have some room or margin to manoeuvre with regards to what they decide to include in the APR.

So, to ensure all is clear; the interest rate is: the actual “base-line” cost of borrowing the principal, as opposed to an APR, which is: almost always higher than the interest rate, because it includes other costs associated with borrowing the money, as shown above.  Consequently, the APR as a “criteria” or “charging benchmark” is very often used by credit card issuers and lenders, as a more effective rate for the consumer to consider as regards the “cost” of a facility, when comparing different lending facilities offered, because of these inclusions.

Having understood the above, here is my issue when it comes to the Card Payments Industry:

While we know that the interest rate determines the cost of borrowing money, and we accept that the APR is a more accurate picture of the total borrowing cost, because it takes into consideration these other “charges”; the consumer still wants transparency, accuracy, and to be able to understand the “true cost” of borrowing. The real difference in “overall charges” in the card payments industry between current interest rates and APR – in spite of these presumed “in-built costs” – demonstrates a complete lack of transparency by the card issuers. Hence the benefits of using APRs are overshadowed by the exorbitant APR figure ultimately levied on the consumer by the Card Issuing Banks.

For example: on a credit card that I used recently, I paid-off part of the principal and interest accrued during the previous period, and “rolled-over” the remaining residual balance to the next period. On receipt of the statement for this next cycle, I saw and understood the interest amount in GBP Sterling added to the outstanding balance; but at an APR of 45%!  I find this figure unreasonable, given that interest rates currently stand at 0.10%.

To put is simply; I am being charged 450 basis points, when the true “wholesale” cost of borrowing (albeit by Financial Institutions in the inter-bank market) is a mere 10 basis points, plus a margin; or thereabouts, on an equivalent LIBOR related basis. Of course, we know for individual retail borrowers and consumers, interest rates are higher; but let’s be realistic, by how much?

In this example, I am being charged an additional margin of 449 basis points; or 44.9%. I do not know the algorithmic arithmetical calculation for computing an APR to a comparable interest rate equivalent (please inform me if you do); but I do know that an APR of 45% is likely to be nearer an interest rate of 20%, when the latter in the UK is currently 0.10%.

So; my questions are:

  • How can this be?
  • And why are Issuing Banks allowed to seemingly “overcharge” the consumer, particularly during these current challenging times of CO-19 and “lockdown”, and even during the financial crisis of 2007/2008 plus, with apparently sky-high APRs, when interest rates were then, and continue to be now, at an all time low?

I am aware that all card issuing institutions under the Bank of England’s “Capital Adequacy” guidelines are charged 100% against the capital held on their balance sheets, in order to cover perceived “weighted risk” for the utilisation of credit card lines and outstanding balances on cards; but the additional items reflected in the extra costs or charges “bundled” into the all-encompassing APR do not in this scenario of consumer credit card utilisation apply here, or even exist; or do they?  Here lies the question; if they do not, why is the APR so high, and so varied depending upon the individual card issuers? What is the answer, greed?

Those actively involved in the Credit Card Industry currently, please enlighten us all.

Eliot Charles Heilpern

Director of Partnerships

The Payments Business

CEO Parthenon Communications

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